Intermediate Financial Accounting I

Intangible Assets

Chapter Outline

Definition and common types of intangible assets Valuation and costs of intangibles Accounting for finite-life intangibles and intangibles with indefinite lives. Accounting for patents, copyrights, franchise and licenses, trade names and trademarks, and start-up costs. Accounting for R&D and computer software costs. Accounting for goodwill
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Definition Of Intangible Assets

Assets --

a. with future economic benefits,

b. no physical substance, c. with high degree of uncertainty concerning the future benefit.
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Common Types of Intangibles

Patents, copyrights, franchises, start-up costs, trade names, trademarks, goodwill etc..

Intangible Assets

Valuation of Intangibles

Intangibles are recorded at cost and are also reported at cost at the end of an accounting period. Intangibles with limited life are subject to amortization and possible impairment test. Intangibles with indefinite life are only subject to impairment test at least annually.
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Costs of Intangibles

Costs of Intangibles include acquisition costs plus any other expenditures necessary to make the intangibles ready for the intended uses (i.e., purchase price, legal fees, filing fees etc.; not including internal R&D). Essentially, the accounting treatment of valuation for intangibles closely parallels that followed by tangible assets.
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Examples
1. Issuance of stock to acquire intangibles.

2. Lump-sum purchase of intangibles. Costs will be allocated in accordance with the fair market value of each individual intangible.

Intangible Assets

Intangibles Assets with Finite lives

Patents (20 years), copyrights (the life of the creator plus 70 years), franchise and license (the contractual life). The costs are subjected to amortization (a process of cost allocation) over the shorter of the legal or useful life, not to exceed 40 years.
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Amortization of Intangibles

The impairment test needed only when events indicate that the book value may not be recoverable.
Amortization Method: Straight-line method.
Other method can be applied if it is more appropriate than the S-L method. Residual value: Usually zero.
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Amortization of Intangibles (contd.)

Journal Entry: Amortization Expense Intangible Asset xxx xxx

(or Accumulated Amortization)

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Intangibles Assets with Indefinite Lives

Trade names, trademarks, goodwill, inprocess R&D.

The costs are not subject to amortization. Impairment test is required at least annually.

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1. Patents

Granted by the U.S. Patent and Trademark Office for a period of 20 years. A patent gives the holder the exclusive right to produce, use and sell a product or process without interference or infringement from others.
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Patents (contd.)

Cost of patent: If purchased from an inventor, the cost will include the purchase price plus any legal fees (to successfully protect the patent).

In addition, any legal fees occur after the acquisition of a patent which successfully defend the right of the patent should also be capitalized.
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Patents (contd.)

The cost of a patent should be amortized over the legal life or the useful life, whichever is shorter.

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Patents (contd.)
Journal Entry Amortization Expense xxx xxx

Patents (or Accu. Patent Amortization)

Using straight-line method (partial year should be applied)

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Patents (contd.)

If events indicate the book value of a patent may not be recoverable, an impairment test is required (see Chapter 11 for details) If a patent becomes worthless, the net value of the patent should be written off as loss. If a patent is internally developed, no cost can be capitalized. Most of the research and development (R&D) costs are expensed.
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2. Copyrights

A federally granted right to authors, sculptors, painters, and other artists for their creations. A copyright is granted for the life of the creator plus 70 years. It gives the creator and heirs an exclusive right to reproduce and sell the artistic work or published work.
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Copyrights (contd.)

If purchased, the cost includes the purchase price plus any legal fees. If developed by the owner (the creator), no cost can be capitalized. Amortization: Straight-line method or a unit-of-production method. Impairment test needed only if events indicate that book value may not be recoverable.
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3. Franchise & License

A franchise is a contractual agreement under which the franchiser grants the franchisee the right to sell certain products or service or to use certain trade names or trademarks.

A license is a contractual agreement between a governmental body (i.e., city, state, etc.) and a private enterprise to use public property to provide services.
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Franchise & License (contd.)

Costs: Franchise fees plus any legal fees should be capitalized. Amortization: over the shorter of the contractual life or the useful life, not to exceed 40 years. Impairment test is needed only if events indicate that the book value may not be recoverable.
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4. Trademarks & Trade Names

A word, a phrase, or a symbol that distinguishes a product or an enterprise from another (i.e., company names, XEROX,)
Cost: Similar to that of copyrights.

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Trademarks & Trade Names

Life: register at the US Patent Office for 10 years life. The registration can be renewed every 10 years for unlimited times.

Amortization: no amortization necessary.

Impairment test is required at least annually.

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5. Start-Up Costs (including Organization

Costs)

Start-up costs: Any costs incurred for the preparation of introducing a new product or new service or start business in a new territory. Org. Costs: Costs associated with the formation of a corporation including fees to underwriters (for stock issuance), legal fees, promotional expenditures, etc.

These costs should be expensed as incurred.

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6. Research and Development (R&D)

Prior to SFAS 2 (effective in 1974), the practice was to either expense or capitalize R&D related expenditures. SFAS 2 requires to expense and disclose all R&D costs if the results of R&D are for internal use.

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6. Research and Development (R&D)

R&D costs include salaries of personnel involved in R&D, costs of materials used, equipments, facilities and intangibles used in R&D activities. If equipment has an alternative usage, the equip. should be capitalized and only the depreciation expense will be included in the R&D expense.
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R&D: An Example
Cash expenditures related to the R&D are as follows: R&D salaries and wages $100,000 R&D material &supplies used 50,000 R&D equip. purchased* 120,000 Payments to others for service performed related to R&D 30,000 Patent filing and legal fees for completed project 25,000

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R&D: An Example (contd.)

*The equipment purchased will be used in other projects and the depreciation on the equipment in 2008 was $ 10,000. R&D expenses include the followings: R&D salary: $100,000; R&D material:$50,000; depre. Expense: $10,000; payments to others: $30,000 . The following expenditures are capitalized: Equipment: $120,000 ; Patent: $25,000.
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R & D Contracts

Costs of R&D performed under contracts for others are capitalized as inventory or receivable. Income from these contracts can be recognized based on percentage-of completion or complete contract method as discussed for the long-term construction contracts.
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Purchased R&D

When acquiring another company, the purchase price is allocated to tangible assets, intangibles (developed technology) and in-process R&D.

The remaining will be the goodwill.

The in-process R&D is expensed prior to 2009.
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Purchased R&D (Contd.)

The fair value of in-process R&D is capitalized as indefinite-life intangible asset for business acquisition made in fiscal years beginning on or after 12/15/2008 (SFAS 141 (revised)). The capitalized in-process R&D should not be amortized but is subject to impairment test.
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International Financial Reporting Standards R&D (IAS 38)

Research expenditures are expenses as incurred. Development expenditures meet certain criteria (i.e., development costs can be measured , the product is technically and commercially feasible and the economic benefits are probable) are capitalized as an intangible asset.
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7. Computer Software Costs

Computer software costs including planning, designing, coding, testing, documentation and preparation of training materials. Expense most of the costs if the software is to be sold. SFAS 86 requires these costs be expensed as R & D expenses prior to the establishment of technological feasibility of the software.
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Costs Associated With a Software

Costs occurred after the establishment of technological feasibility but before the software is ready for general release are capitalized as an intangible asset.

Costs occurred after the software is ready for general release and production are recognized as produce costs (will be expensed as CGS later).
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8. Goodwill

Cannot be separated from the business. Can only be recognized if the whole business was purchased and the purchase price is greater than the market value of the net assets (i.e., market value of assets market value of liabilities).
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Factors Contribute to Goodwill

Superior

management team. sales organization. tax condition.

Outstanding Favorable Effective Good

advertising.

labor relations.

Outstanding

credit rating.
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Methods of Measuring Goodwill

Theoretically, estimate the value of each factor which contributes to the goodwill (not practical).
There are two alternatives used in measuring goodwill:

a. Master valuation approach. b. Capitalization of excess earnings power.

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a. Master Valuation Approach

Goodwill1 = Purchase price of a business - market value of net assets of the business. Market value of net assets = M.V. of assets - M.V. of liabilities.
1. Goodwill is measured as the excess of cost over the fair value of the identifiable net assets acquired.
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b. Capitalization of Excess Earnings Power

Excess earnings power = the difference between what a firm earns and what is normally earned for a similar firm in the same industry.

Goodwill = Discounting the excess earnings over the estimated life of the excess earnings.
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b. Capitalization of Excess Earnings Power (contd.)

Example Excess earning = $10,000 Discount Rate = 10% Estimated life = 10 years

Goodwill = $10,000 x 6.145 = $61,450 annuity, 10 -period, 10%

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b. Capitalization of Excess Earnings Power (contd.)

Excess Earnings = annual average earnings of a firm (excluding extraordinary items) normal annual earnings of a similar firm in the industry. Normal earnings = industry rate of return on assets the market value of the acquired firms net assets.
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Goodwill (contd.)

Recording of Acquisition: Assets (at market value) xxx Goodwill xxx Liability (at market value) xxx Cash xxx

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Goodwill (contd.)

Amortization of goodwill is abolished by SFAS No. 142, effective July 2002. Goodwill is subject to impairment tests at least annually. See the notes in chapter 11 for Assets Impairment for the goodwill impairment procedures.

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Negative Goodwill

Negative Goodwill: Cannot be recognized.

(in the case when price paid is less than the market value of the net assets)

The negative goodwill is used to reduce the costs assigned to the noncurrent assets acquired. The reduction is proportionately to the relative market value of the noncurrent assets.
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Impairment of Intangible Assets

(see Impairment Notes in Ch. 11 for Details)

All principles (SFAS 144) apply to impairments of long-lived assets also apply to intangible assets.

Thus, when changes in circumstances indicate that the book value of the intangibles may not be reconcilable (i.e., fair value of intangible < carrying amount), a write-down should be performed to recognize the loss.
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Impairment of Intangible Assets (contd.)

Example:
Carrying amount of a copyright Fair value Loss on Impairment The journal entry to record the loss: Loss on Impairment 700,000 Copyright
Intangible Assets

$1,200,000 500,000 $700,000

700,000
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Summary of the Chapter

Intangible Patent Legal Life 20 Amortization The shorter of useful or legal life

Copyrights

Life of creator + 70 years

Contractual agreements Unlimited (renewed every 10 years) Unlimited Unlimited
Intangible Assets

The shorter of useful or legal life not to exceed 40 years

The shorter of contractual Life or useful life Impairment test only (at least annually) Impairment test only Impairment test only
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Franchises or Licenses Trade Names & Trademarks In-Process R&D Goodwill